What to do with banks that are ‘too big to fail’?

PARIS – JPMorgan Chase has had a bad year. Not only has the bank just reported its first quarterly loss in more than a decade; it has also agreed to a tentative deal to pay a fine of $13 billion to the U.S. government as punishment for mis-selling mortgage-backed securities. Other big legal and regulatory costs loom. JPMorgan will bounce back, of course, but its travails have reopened the debate about what to do with banks that are “too big to fail.”

In the United States, policymakers chose to include the Volcker rule (named after former Federal Reserve Chairman Paul Volcker) in the Dodd-Frank Act, thereby restricting proprietary trading by commercial banks rather than reviving some form of the Glass-Steagall Act’s division of investment and retail banks.

But Senators Elizabeth Warren and John McCain, a powerful duo, have returned to the fight. They argue that recent events have shown that JPMorgan is too big to be managed well, even by CEO Jamie Dimon, whose fiercest critics do not accuse him of incompetence.

Nonetheless, the Warren-McCain bill is unlikely to be enacted soon, if only because President Barack Obama’s administration is preoccupied with keeping the government open and paying its bills, while bipartisan agreement on what day of the week it is, let alone on further financial reform, cannot be guaranteed. But the question of what to do about huge, complex, and seemingly hard-to-control universal banks that benefit from implicit state support remains unresolved.

The “school solution,” agreed at the Financial Stability Board in Basel, is that global regulators should clearly identify systemically significant banks and impose tougher regulations on them, with more intensive supervision and higher capital ratios. That has been done.

Initially 29 such banks were designated, together with a few insurers — none of which like the company that they are obliged to keep! There is a procedure for promotion and relegation, as in national football leagues, so the number fluctuates periodically. Banks on the list must keep higher reserves, and maintain more liquidity, reflecting their status as systemically important institutions. They must also prepare what are colloquially known as “living wills,” which explain how they would be wound down in a crisis — ideally without taxpayer support.

But while all major countries are signed up to this approach, many of them think that more is needed. The U.S. now has its Volcker rule (though disputes between banks and regulators about just how to define it continue). Elsewhere, more intrusive rules are being implemented, or are under consideration.

In the United Kingdom, the government created the Vickers Commission to recommend a solution. Its members proposed that universal banks be obliged to set up ring-fenced retail-banking subsidiaries with a much higher share of equity capital. Only the retail subsidiaries would be permitted to rely on the central bank for lender-of-last-resort support.

A version of the Vickers Commission’s recommendations, which is somewhat more flexible than its members proposed, is in a banking bill currently before Parliament. A number of Parliament members want to impose tighter restrictions, and it is difficult to find anyone who will speak up for the banks, so some form of the bill is likely to pass, and big British banks will have to divide their operations and their capital.

The U.K. has decided to take action before any Europe-wide solution is agreed. We British are still members of the European Union (at least for the time being), but sometimes our politicians forget that. Sometimes they simply lose patience with the difficulty of agreeing on changes in negotiations that involve 28 countries, which seems especially true of financial reform, given that many of these countries are not home to systemically important banks and probably never will be.

But EU institutions have not been entirely inactive. The European Commission asked an eminent-persons group, chaired by Erkki Liikanen, the head of the Finnish central bank, to examine this issue on a European scale.

The group’s report, published in October 2012, came to a similar conclusion as the Vickers Commission concerning the danger of brigading retail and investment banking activities in the same legal entity, and recommended separating the two. The proposal mirrors the U.K. plan — the investment-banking and trading arms, not the retail side, would be ring-fenced — but the end point would be quite similar. The European Banking Federation has dug in its heels, describing the recommendations as “completely unnecessary.”

The European Commission asked for comments, and its formal position is that it is considering them along with the reports.

That consideration may take some time; indeed, it may never end. Germany’s government seems to have little appetite for breaking up Deutsche Bank, and the French have taken a leaf from the British book and implemented their own reform. The French plan looks more like a Gallic version of the Volcker rule than Vickers “à la française.” It is far less rigorous than the banks feared, given President François Hollande’s fiery rhetoric in his electoral campaign last year, in which he anathematized the financial sector as the true “enemy.”

So we now have a global plan, of sorts, supplemented by various home-grown solutions in the U.S., the U.K. and France, with the possibility of a European plan that would also differ from the others.

In testimony to the U.K. Parliament, Volcker gently observed that “Internationalizing some of the basic regulations [would make] a level playing field. It is obviously not ideal that the U.S. has the Volcker rule and [the U.K. has] Vickers …”

He was surely right, but “too big to fail” is another area in which the initial post-crisis enthusiasm for global solutions has failed. The unfortunate result is an uneven playing field, with incentives for banks to relocate operations, whether geographically or in terms of legal entities. That is not the outcome that the Group of 20 — or anyone else — sought back in 2009.